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Thursday, October 3, 2013

Selecting the Form of Payment: Signaling and Overvaluaton

Selecting the form of
payment in an acquisition is a function of many factors. What
post-acquisition ownership structure is desired? What are the tax
consequences? How much cash does the acquiring firm have? Is the
acquiring/target firm stock overvalued? What are the legal ramifications
for this form of payment? What does the target desire?

These are but a few of the
payment related factors to consider in selecting form of payment. We'll
discuss just one aspect here - the concept of signaling and overvaluation.
Firm's that use stock to acquire other firms tend to experience a small
drop in the market value of their shares. Similar results are found for
firms issuing equity.

What explains the loss of
market value? The evidence is consistent with the Signaling
Hypothesis, which suggests that the use of stock is because the acquiring
firm's managers believing that their stock is overvalued.

Consider the following
scenario - you are CEO of a firm whose shares are trading at $30. You believe,
however, that the shares are worth $20. Thus, the shares are overvalued
by 50%. Now eventually, the market may 'wise up' and revalue your shares.
As a way to create value for existing shareholders you
consider exchanging the overvalued equity for hard assets of another firm.
In this way you 'lock - in ' the excess value even if shareholders
recognize your current overvaluation.

Now consider using shares
for acquisitions. Would you do so if you thought the shares were
undervalued? Probably not, you'd be giving away value. Thus the
prevailing wisdom is that firms using stock don't think it is undervalued.

Empirical evidence, showing
stock drops on the order of 3% at the announcement of a stock deal, are
consistent with this idea.

We'll discuss these and
other ideas in great detail in Amsterdam, just
over two months from now(see side note or click here)

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About MergerProf

In addition to their day jobs, Joe and Ralph teach acquisition finance at the Amsterdam Institute of Finance. This blog was created in the summer of 2012 as a tool for those interested in acquisition finance and related material. Admittedly, we define related material broadly to include mergers, private equity, banking, governance, deal making and, well, finance in general. We hope you will enjoy and contribute, critiquing, expanding and providing your own examples related to the posts. We encourage you to join us in this adventure and, for some of you, to see you in Amsterdam, New York or Philadelphia.